TCS Daily

Merkel Outfoxed, or Leading the Pack?

On her way to becoming Germany's first female chancellor, Angela Merkel has signed off on a policy platform that seems designed for failure: multiple tax hikes on a sluggish economy, modest restraints on state spending and virtually no initiatives to spur growth other than state-directed "innovation subsidies". Has Merkel traded away the very essence of her campaign pitch, or does she have a plan to outfox her critics and opponents (at least those among her ostensible allies)?

There is no doubt that creation of Germany's "grand coalition" (CDU/CSU and SPD), a result of Merkel's poor showing in the election, forestalled any true growth strategy, including tax rate cuts, restraint on social welfare spending, and market-freeing regulatory relief, particularly regarding labor. Yet even with modest expectations from the public, the platform unveiled by the coalition on November 11 is dismal indeed: a 3-point hike in the VAT rate to 19 percent (Merkel herself only proposed 18 percent), a new 3 percent wealth tax penalty on so-called upper income earners, cuts in tax breaks for homeowners and commuters, and delaying business tax cuts until 2008 (last spring outgoing SPD Chancellor Gerhard Schröder proposed cutting the top business rate from 25 percent to 19 percent).

Germany, with unemployment approaching 12 percent and economic growth projected at 1 percent or less, is not wont to prosper with this tax-driven fiscal austerity. True, the coalition platform does envision some restraints on social spending down the road, including a proposed jump in the retirement age to 67 years (to be implemented only by the year 2035) and somewhat less generous pension and retirement benefits. In addition a portion of increased VAT revenues will be aimed at offsetting cuts in unemployment insurance costs for German businesses, in an effort to promote job creation by socializing more broadly the cost of those benefits.

Yet socializing costs doesn't reduce them, and without more serious constraints on state spending (including the much vaunted "social compact" panoply of welfare benefits) it is difficult to see how the grand coalition can reach its grand goal of slashing Germany's budge deficit to bring it in line with the European Union's rule limiting deficits to 3 percent of GDP. True, the coalition puts most of the pain off until 2007, hoping that a year of sheer terror will induce Germans to spend and invest in 2006 like it was their last chance. Yet absent a serious growth agenda it is both naïve and futile to assume that increasing the VAT rate will actually bring in more revenue. If the coalition tax hikes slow growth further, as many economists predict, consumers will buy less and all bets are off on revenue projections for the VAT (and the new "wealth tax" for that matter).

How did Germany get in this fiscal box? Well, Merkel and her coalition partners cite the EU mandate to cut the budget deficit as a critical consideration, and the EU is ever committed to the high-tax option as the only way to balance income and outgo. Yet EU rules, as in much of Europe these days, provide a convenient excuse for politicians with no place to go to hide behind the EU's rhetoric. Avoiding accountability to German voters for controversial austerity measures may seem like a lowest-common-denominator recipe for political survival to this coalition.

But surely greater accountability to voters is just what the German government needs. In the election campaign Merkel and Schröder both were seen as advocating a certain degree of austerity, but Merkel promised more of it, allowing Schröder to call her "heartless" and bringing her to the brink of defeat. Even German voters, wedded as they are to the social welfare state, might have responded to the notion that their beloved benefits could be protected only by moving the nation to a higher-growth path: a goal which demands serious tax and regulatory relief. But Merkel never got to make that case, or she would be in a stronger position now.

Ironically, even as Germany embraces EU calls for fiscal austerity, in Washington IMF Managing Director Rodrigo Rato called for the US to raise taxes to reduce its budget deficit, while discounting the option of spending restraint (indeed the IMF is saying the same thing to Japan, but this is what it usually says). If Europe, the US, and Asia raise taxes at the same time, in tandem with higher energy costs and US monetary tightening, deficit finance will remain unavoidable for some time, and the risk of global recession cannot be ruled out.

Is there a silver lining anywhere? Perhaps. The Coalition under Merkel still proposes a few more labor reforms than the SPD wanted, including a significant delay in an employee's initial eligibility for unemployment benefits. Even the adjustment of the retirement age - pathetically timid as the proposition may seem - would be an important step in the right direction. The more nuanced foreign policy that we can expect from the new government will help if it means that Germany takes less advice from France in matters of the economy, and opens itself more to suggestions from the UK, the United States and the new members of the EU to the east, including lower tax rates that at least will be competitive with nations moving towards the flat tax.

Under the circumstances, it will be hard for Merkel to emerge as a champion of economic freedom from the certain economic failure that the coalition platform will ensure. Her political pragmatism in forming a government at any cost - since there was no viable alternative to the SPD/CDU mismatch - has made Angela Merkel the chancellor but seems to have stripped her of all the reasons that made her deserve to become the chancellor. It is highly unlikely that the opportunity to move German economic policies into the 21st century will be seized by this government.

This is unfortunate, as Germany has a unique opportunity to bridge the divide between the traditional continental European consensus and Europe's more progressive upstarts to the east. Merkel is going to have a difficult time distancing herself from the failure of coalition economic policies, and seizing the mantle of progressive economics - but if she does not someone else will. If Germany is not to give up on itself, its aging and underemployed population, and indeed Europe as a whole, early elections will have to put an end to a coalition that has failed, before it even started.

George A. Pieler is a Senior Fellow with the Institute for Policy Innovation and former Tax Counsel to the Senate Finance Committee. Jens F. Laurson is Editor of the International Affairs Forum.